The Theory of Consumer Choice

11/12/2019
N. GREGORY MANKIW
Look for the answers to these questions:
PRINCIPLES OF
 How does the budget constraint represent
MICROECONOMICS the choices a consumer can afford?
Eighth Edition
 How do indifference curves represent the
consumer’s preferences?
 What determines how a consumer divides
CHAPTER The Theory of her resources between two goods?
 How does the theory of consumer choice
Consumer Choice explain decisions such as how much a
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consumer saves, or how much labor she
V. Andreea CHIRITESCU
Eastern Illinois University
supplies?
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 2
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management system for classroom use. management system for classroom use.
1 2
The Budget Constraint:

Introduction What the Consumer Can Afford
 People face tradeoffs.  Budget constraint:
– Buying more of one good leaves less – The limit on the consumption bundles that
income to buy other goods a consumer can afford
– Working more hours means more income  Example:
and more consumption, but less leisure
– Hurley divides his income between two
time
goods: fish and mangos.
– Reducing saving allows more consumption
– A “consumption bundle” is a particular
today but reduces future consumption
combination of the goods, e.g., 40 fish &
300 mangos
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 3 as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 4
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Active Learning 1: The budget constraint Active Learning 1: Answers

Hurley’s income: $1200 A. $1200/$4 Quantity D. Hurley’s budget
Prices: PF = $4 per fish, PM = $1 per mango of Mangos constraint shows
= 300 fish B
the bundles he can
A. If Hurley spends all his income on fish, how many afford.
fish does he buy? B. $1200/$1
= 1200 C
B. If Hurley spends all his income on mangos, how
mangos
many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can he C. 100 fish cost
buy? $400,
D. Plot each of the bundles from parts A – C on a $800 left buys
graph that measures fish on the horizontal axis 800 mangos A
and mangos on the vertical; connect the dots. Quantity
of Fish
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Active Learning 1:The Slope of the Budget Constraint Active Learning 2: The budget constraint, continued
The slope of the Initial problem:
From C to D, of Quantity
Mangos budget constraint
“rise” = equals the relative Hurley’s income: $1200
–200 mangos price of the good Prices: PF = $4 per fish, PM = $1 per mango
on the X axis.
“run” = C Show what happens to Hurley’s budget
+50 fish D constraint if:
Slope = – 4 A. His income falls to $800.
Hurley must B. The price of mangos rises to PM = $2 per
give up mango
4 mangos
to get one fish. Quantity
of Fish
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Active Learning 2: Answers, Part A Active Learning 2: Answers, Part B

Now,
Quantity Hurley Quantity
of Mangos
Hurley A fall in income can still buy of Mangos
An increase in the
can buy shifts the budget 300 fish. price of one good
constraint down. pivots the budget
$800/$4 But now he
constraint inward.
= 200 fish can only buy
$1200/$2 =
or 600 mangos.
$800/$1
= 800 mangos Notice: slope is
smaller, relative
or any price of fish is now
combination in Quantity only 2 mangos Quantity
of Fish
between. of Fish
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Preferences: What the Consumer Wants Four Properties of Indifference Curves

1. Indifference curves are downward-
Indifference curve: One of Hurley’s sloping. One of Hurley’s
Quantity Quantity
shows consumption of Mangos indifference curves of Mangos indifference curves
bundles that give the If the quantity of
consumer the same fish is reduced,
level of satisfaction the quantity of
B mangos must be B
A, B, and all other increased to keep
bundles on I1 make A Hurley equally A
Hurley equally happy: I1 happy. I1
he is indifferent
between them.
Quantity Quantity
of Fish of Fish
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Four Properties of Indifference Curves Four Properties of Indifference Curves

2. Higher indifference curves are preferred 3. Indifference curves cannot cross.
to lower ones. Quantity A few of Hurley’s Suppose they did. Quantity Hurley’s
of Mangos indifference curves of Mangos indifference curves
Hurley should prefer
Hurley prefers B to C, since B has
every bundle on I2
more of both goods.
(like C) to every
bundle on I1 (like Yet, Hurley is indifferent B
C between B and C:
A). D
I2 C
He prefers every A He likes C as much as A A
bundle on I1 (like I1 (both are on I4). I1 I4
A) to every bundle I0 He likes A as much as B
on I0 (like D). Quantity (both are on I1). Quantity
of Fish of Fish
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Four Properties of Indifference Curves The Marginal Rate of Substitution

4. Indifference curves are bowed inward. Marginal rate of
Quantity
substitution (MRS): Quantity MRS = slope of
of Mangos the rate at which a of Mangos indifference curve
Hurley is willing to consumer is willing to
give up more trade one good for another.
A A
mangos for a fish if
he has few fish (A) 6
Hurley’s MRS is the MRS = 6
than if he has many amount of mangos he
1 1
(B). B would substitute for another B
2 fish. MRS = 2
1 I1 1 I1
MRS falls as you
move down along
Quantity Quantity
of Fish an indifference curve. of Fish
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One Extreme Case: Perfect Substitutes Another Extreme Case: Perfect Complements
Perfect substitutes: two goods with Perfect complements: two goods
straight-line indifference curves, with right-angle indifference curves
constant MRS Example: Left shoes, right shoes
Example: nickels and dimes {7 left shoes, 5 right shoes}
is just as good as
Consumer is always willing to
trade two nickels for one dime. {5 left shoes, 5 right shoes}
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Less Extreme Cases: Optimization: What the Consumer Chooses

Close Substitutes and Close Complements Quantity
A is the optimum: of Mangos
The optimum
Quantity Indifference Quantity Indifference the point on the budget
of hot curves for is the bundle
of Pepsi curves for close constraint that touches
dog buns close Hurley most
substitutes are
the highest possible prefers out of
not very bowed complements 1200
are very indifference curve. all the bundles
bowed he can afford.
Hurley prefers B to A, B
but he cannot afford B. 600 A
C
Hurley can afford C and
D
D, but A is on a higher
Quantity Quantity indifference curve. 150 300 Quantity
of Coke of hot dogs
of Fish
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Optimization: What the Consumer Chooses The Effects of an Increase in Income

Quantity
of Mangos Consumer
At the optimum, optimization is An increase in Quantity
of Mangos
slope of the another example income shifts the
indifference curve 1200 of “thinking at the budget constraint
equals slope of the margin.” outward.
budget constraint:
If both goods are B
A A
MRS = PF / PM 600 “normal,” Hurley
buys more of each.
marginal
price of fish
value of fish
(in terms of
(in terms of 150 300 Quantity
mangos) Quantity
mangos) of Fish of Fish
21 22
Active Learning 3: Inferior vs. normal goods Active Learning 3: Answers

Quantity
An increase in income increases the quantity of Mangos
demanded of normal goods and reduces the  If mangos are

quantity demanded of inferior goods. inferior, the
 Suppose fish is a normal good new optimum
but mangos are an inferior good. will contain
 Use a diagram to show the effects of fewer mangos. A
B
an increase in income on Hurley’s optimal
bundle of fish and mangos.
Quantity
of Fish
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The Effects of a Price Change

The Income and Substitution Effects
Initially, Quantity
of Mangos
A fall in the price of fish has two effects on
PF = $4
Hurley’s optimal consumption of both goods
PM = $1 1200
initial
optimum
 Income effect
– A fall in PF boosts the purchasing power of
PF falls to $2 new
optimum Hurley’s income: buy more mangos and more fish
budget constraint 600
rotates outward, 500  Substitution effect
Hurley buys – A fall in PF makes mangos more expensive
more fish and relative to fish: Hurley buys fewer mangos and
fewer mangos. more fish
150 300 600 Quantity
350 of Fish The net effect on mangos is ambiguous.
25 26
The Income and Substitution Effects Deriving Hurley’s Demand Curve for Fish
Quantity A: When PF = $4, Hurley demands 150 fish.
Initial optimum at A. of Mangos B: When PF = $2, Hurley demands 350 fish.
In this example,
PF falls. the net effect Quantity Price of
on mangos is of Mangos Fish
Substitution effect: negative.

from A to B,
buy more fish and $4
A
A
fewer mangos. C A
B
Income effect: B B
$2
from B to C, DFish
buy more of both Quantity
goods. of Fish 150 350 Quantity 150 350 Quantity
of Fish of Fish
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Application 1: A Giffen Good

Application 1: Giffen Goods Quantity of
Potatoes Initial budget
1. An increase in the price of potatoes
Do all goods obey the Law of Demand? B constraint
rotates the budget constraint inward . . .
– Suppose the goods are potatoes and

meat, and potatoes are an inferior good. D Optimum with high
price of potatoes
– If price of potatoes rises, 2. . . . which

New
budget
E
increases potato
• Substitution effect: buy less potatoes consumption if
constraint
C
Optimum with low
price of potatoes
potatoes are a
• Income effect: buy more potatoes Giffen good. I1
I2
– If income effect > substitution effect, A
then potatoes are a Giffen good, a good 0

In this example, when the price of potatoes rises, the consumer’s optimum shifts from point
Quantity of Meat
for which an increase in price raises the C to point E. In this case, the consumer responds to a higher price of potatoes by buying less
meat and more potatoes.
quantity demanded.
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Application 2: Application 2: Wages and Labor Supply

Wages and Labor Supply
Consumption
 Budget constraint
– Shows a person’s tradeoff between $5,000
consumption and leisure At the optimum,
– Depends on how much time she has to divide the MRS between
between leisure and working leisure and
Optimum
consumption
– The relative price of an hour of leisure is the
I3 equals the wage.
amount of consumption she could buy with an 2,000
hour’s wages I2
I1
 Indifference curve 0 60 100
– Shows “bundles” of consumption and leisure Hours of leisure
that give her the same level of satisfaction
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Application 2: Application 2: Wages and Labor Supply

Wages and Labor Supply
For this person, So her labor supply
 An increase in the wage has two effects SE > IE increases with the wage
on the optimal quantity of labor supplied: Consumption Wage
BC2
– Substitution effect (SE): A higher wage makes Labor supply
leisure more expensive relative to
B
consumption.
• The person chooses less leisure (increases I2
quantity of labor supplied) A

1. When the wage rises . . .
BC1
– Income effect (IE): With a higher wage, I1
0
she can afford more of both “goods.” Hours of Leisure
0
Hours of Labor
2. . . . hours of leisure decrease . . . Supplied
• She chooses more leisure (reduces quantity of 3. . . . and hours of labor increase
labor supplied)
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Application 2: Wages and Labor Supply Could This Happen in

For this person, So his labor supply falls
the Real World???
SE < IE when the wage rises  Cases where the income effect on labor
Consumption Wage supply is very strong:
BC2
– Over last 100 years, technological progress
1. When the wage rises . . .
Labor supply has increased labor demand and real wages.
• The average workweek fell from 6 to 5 days.
I2 – When a person wins the lottery or receives
I1
an inheritance, his wage is unchanged—
BC1 hence no substitution effect.
0 0
Hours of Leisure
2. . . . hours of leisure increase . . .
Hours of Labor
Supplied
• But such persons are more likely to work
3. . . . and hours of labor decrease
fewer hours, indicating a strong income effect
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Application 3: Application 3: Interest Rates and Saving

Interest Rates and Saving
Consumption Budget constraint
 A person lives for two periods. when Old
shown is for 10%
– Period 1: young, works, earns $100,000, $110,000 interest rate.
consumption = $100,000 minus amount saved
At the optimum,
– Period 2: old, retired, consumption = saving
the MRS between
from Period 1 plus interest earned on saving Optimum
55,000 current and future
 The interest rate I3
consumption
– Determines the relative price of I2 equals the interest
I1
consumption when young in terms of rate.
0 $50,000 100,000
consumption when old Consumption when Young
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Application 3: Interest Rates and Saving Application 3: Interest Rates and Saving
(b) Higher Interest Rate Lowers Saving
(a) Higher Interest Rate Raises Saving
Consumption
Consumption when 1. A higher interest rate
when old BC2
1. A higher interest rate rotates the budget
old BC2
rotates the budget constraint outward . . . In this case,
constraint outward . . . In this case, SE < IE and
SE > IE and saving falls
2. . . . resulting in
I2 lower consumption
saving rises I2
2. . . . resulting in
higher consumption
when young and, I1
when young and,
thus, higher saving. thus, lower saving.
BC1 BC1
I1 0
0 Consumption when Young
Consumption when Young
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Conclusion:
Do People Really Think This Way?
 People do not make spending decisions
by writing down their budget constraints and
indifference curves.
– Yet, they try to make the choices that maximize
their satisfaction given their limited resources.
– The theory in this chapter is only intended as a
metaphor for how consumers make decisions.
– It explains consumer behavior fairly well in many
situations and provides the basis for more
advanced economic analysis.
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 41
management system for classroom use.
41

The Theory of Consumer Choice

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11/12/2019

The Budget Constraint:

Active Learning 1: The budget constraint Active Learning 1: Answers

Active Learning 2: Answers, Part A Active Learning 2: Answers, Part B

Preferences: What the Consumer Wants Four Properties of Indifference Curves

Four Properties of Indifference Curves Four Properties of Indifference Curves

Four Properties of Indifference Curves The Marginal Rate of Substitution

Less Extreme Cases: Optimization: What the Consumer Chooses

Optimization: What the Consumer Chooses The Effects of an Increase in Income

Active Learning 3: Inferior vs. normal goods Active Learning 3: Answers

demanded of normal goods and reduces the  If mangos are

The Effects of a Price Change

Substitution effect: negative.

Application 1: A Giffen Good

– Suppose the goods are potatoes and

– If price of potatoes rises, 2. . . . which

then potatoes are a Giffen good, a good 0

Application 2: Application 2: Wages and Labor Supply

Application 2: Application 2: Wages and Labor Supply

quantity of labor supplied) A

Application 2: Wages and Labor Supply Could This Happen in

Application 3: Application 3: Interest Rates and Saving

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